Faster Growth Will Come If Governments Raise Their Game

By the Editors -
Dec 26, 2012

Growth in the world economy subsided
in 2012. The expansion since 2009 has been a bitter
disappointment because much of the slack created by the great
recession remains. With so much idle capacity, an opportunity
exists for robust growth in 2013, but only if governments raise
their game.

This recovery was always going to be slow and troubled. A
crash brought on by public and private overborrowing pushes
prices down and deters business investment as distressed
debtors, struggling to repair their balance sheets, quit
spending. Yet wherever you look, political failure is holding
economies back. Things don’t have to be this bad.

When the figures are in, global growth will probably be
less than 3.5 percent in 2012 -- down from 3.8 percent in 2011,
itself a disappointing year. The advanced economies will
probably increase their output by less than 1.5 percent. Europe
is back in recession. With unemployment still high in every
major economy and extraordinarily high in some, the sluggishness
is unacceptable.

Every economy has its unique problems, yet political
failure is a recurring theme. In some of the biggest economies,
this takes a similar form: Governments have failed to get fiscal
policy working as it should, meaning adequate short-term
stimulus combined with credible medium-term control.

Austerity Traps

Premature fiscal contraction (or inadequate fiscal support
in the first place) is plainly holding back growth in the U.S.,
the European Union and Japan. Governments are trapped in undue
austerity because they can’t or won’t commit themselves to
tighten later, when their economies could better stand it. To
maintain financial-market confidence, governments have gone
overboard with fiscal tightening.

Hamstrung by lack of credibility, governments have also
delegated stimulus to central banks. The U.S. Federal Reserve
has responded with remarkable innovations, including
quantitative easing on a huge scale. As of this month, the Fed
says it will apply aggressive monetary stimulus until
unemployment falls to 6.5 percent or inflation rises to 2.5
percent.

The European Central Bank, still an infant, has less
political room to maneuver. Still, it has promised to do
“whatever it takes” to preserve the euro system and has begun
a QE program of its own. The more rigidly conservative Bank of
Japan has so far dragged its feet -- and Japan’s prolonged
stagnation is the result. To force the Bank of Japan’s hand, the
newly elected prime minister, Shinzo Abe, has issued barely
veiled threats to its independence.

Trouble is, monetary stimulus isn’t the first-choice policy
under current conditions. Nominal interest rates can’t be cut to
less than zero -- hence the resort to QE. But unorthodox
stimulus only works if it raises expectations of higher
inflation, which central banks are loath to admit, much less
advertise. This reluctance makes the policy partly self-
canceling.

With fiscal policy broken, we don’t doubt that aggressive
central-bank easing is the right course. Still, it would be much
better to mend fiscal policy, the tool of first resort, once
nominal rates have been cut to nothing.

Japan, with public debt that is more than double the size
of the economy, has little if any remaining fiscal capacity. The
U.S. and Europe, however, have room to maintain or increase
short-term fiscal support, so long as clear, binding plans for
longer-term restraint are in place. Instead, on both sides of
the Atlantic, there is total disarray over budgetary policy.

Ambitious Goal

In the U.S., breaking the impasse over the so-called fiscal
cliff is only a first, albeit vital, step. The White House and
both parties on Capitol Hill must also agree to a binding plan,
similar to what President Barack Obama’s fiscal commission has
proposed, to bring the ratio of public debt to gross domestic
product back below 50 percent.

That is a more ambitious goal than either side has
suggested so far. With this in place, fiscal stimulus in the
short term would be feasible. Greater certainty plus relief from
the short-term squeeze would give growth in 2013 a double lift.

There is no excuse for Washington’s perpetual fiscal
paralysis. Getting policy right in Europe, in contrast, is
genuinely difficult. There, fiscal reform involves
constitutional reform. Lifting the threat of insolvency from
Spain and Italy -- it’s too late for Greece -- requires further
pooling of sovereignty, to allay the justified fears of Germany
and other countries that they will be on the hook permanently
for southern profligacy.

Yet hardly anyone in the union wants to take a big stride
toward a United States of Europe right now, least of all in
Germany. New fiscal arrangements shouldn’t wait on grandiose
ambitions. Europe should do the minimum necessary to keep
borrowing rates sustainable -- perhaps with fiscal transfers or
conditional, collectively guaranteed bonds, as we have
recommended. It is a debate Germany may want to postpone until
after its elections in 2013. Every month’s further delay is
dangerous.

It is a good sign that the EU has just advanced a plan for
a single bank supervisor, a measure needed since the beginning
of the euro system. Still missing, though, are an EU-wide
deposit-guarantee system and a method for shutting down
insolvent banks. A currency union needs all three.

Nasty Surprises

In the developing economies, fiscal issues are less
pressing, though 2013 could bring nasty surprises. China,
bouncing back from its own pause earlier this year, remains a
concern. Many economists fear the consequences of too much bank-
financed, locally directed public investment. China’s new
leadership, preoccupied with fighting corruption, needs to get a
grip on local government spending and to marshal its resources
in case those debts go bad and end up on the central
government’s books. Efforts to make consumption, not investment,
drive growth need to be redoubled.

India should be the other great engine of global
prosperity, but has the opposite problem: It is investing too
little in infrastructure. This year’s power failures couldn’t
have made the point more forcefully. Even more than China’s, its
government has aroused fears that the earlier zeal for pro-
market reform has faded. In recent weeks, a new policy team has
promised to revive those efforts. A lot is riding on their
success.

China and India underline a point often forgotten in the
rich economies: Important as demand may be, supply-side reforms
are the keys to longer-term growth. A great danger everywhere --
especially in the U.S., where it has come as a shock -- is the
rise of long-term unemployment. Skills atrophy and the will to
work fades with prolonged joblessness. It is still possible to
arrest this decay with better demand management and measures
aimed directly at the labor market, such as more support for job
search, retraining and midcareer education. Soon, it might be
too late.

Wherever you look, better domestic policy is the path to
faster global growth. International coordination has a big
supporting role, though, and it has also been neglected.
Progress toward an effective system of global bank regulation
has been halting: Governments have delayed putting into force
the new Basel rules for capital adequacy, and the intended new
requirements aren’t nearly stringent enough. Long-stalled global
trade talks aren’t formally deceased, though it is hard to tell
the difference. Negotiations on a successor to the failed Kyoto
Protocol have yet to move things forward on climate change.

These domestic and international policy failures all prompt
the question: Is anybody in charge? Effective policy action
early in the recession prevented an outright economic
catastrophe, and governments deserve much credit for that. But
their performance more recently has ranged from flawed to
lamentable. They will have to do better if 2013 is to deliver
the advances in incomes and employment the world needs.